EFIN/MFIN 301 Corporate Finance Han Özsöylev (8) MECHANICS OF CAPITAL BUDGETING
THE VALUATION PROCESS Valua%on is an itera%ve process 5. Calculate and Interpret Results Once the model is complete, examine valua8on results to ensure your findings are technically correct, your assump8ons are realis8c, and your interpreta8ons plausible. 4. Compute the Cost of Capital To value the enterprise, free cash flow is discounted by the weighted average cost of capital. The cost of capital is the blended rate of return for all sources of capital, specifically debt & equity. 3. Es%mate a Con%nuing Value To forecast cash flows in the long- term future, use a perpetuity that focuses on the company s key value drivers, specifically ROIC and growth. 1. Analyze Historical Performance By thoroughly analyzing the past, we can document whether the company has created value, whether it has grown, and how it compares with its compe8tors. 2. Forecast Financials & Cash Flows Project financials over the short and medium term. Short- term forecasts should be consistent with announced opera8ng plans. Medium- term forecasts should focus on opera8ng drivers, such as margins. Begin the process by analyzing historical performance hmp://www.youtube.com/watch?v=lc791is6x0o
EFCF versus FFCF Investment cash flow is the sum of the cash inflows and outflows from the project Equity free cash flow (EFCF): cash flow available for distribution to the firm s common shareholders Values the equity claim in the project Includes cash dividends and share repurchases Firm free cash flow (FFCF): cash flows available for distribution to both the firm s creditors and equity holders Values the firm as a whole (both equity and debt claims)
EFCF FOR UNLEVERED FIRM = FFCF FFCF = EFCF Unlevered Firm = EBIT(1 - T) + DA - WC CAPEX EBIT: Earnings before interest and taxes EBIT(1 - T): A]er- tax opera8ng income or net opera8ng profit a]er tax (NOPAT) T: Tax rate DA: Deprecia8on and amor8za8on expense WC: Change in net working capital CAPEX: Capital expenditures for property, plant, and equipment
EFCF ADJUSTED FOR USE OF DEBT FINANCING EFCF = (EBIT- I) (1 - T) + DA - CAPEX - WC P + NP (EBIT I)(1 - T): Net income a]er taxes P: Principal payments on the firm s outstanding debt NP: Net proceeds from the issuance of new debt When a firm uses debt the two cash flow consequences are net proceeds (inflow) and cash outlays for principal and interest payments. Since interest expense is tax deduc8ble, it reduces the taxes the firm has to pay.
LANGUAGE OF CAPITAL BUDGETING FFCF t = [ (Revenues t ) - (Cost of goods sold t ) - (Op exp t ) - DA t ] x (1- T) + DA t CAPEX t - WC t
INVESTMENT ANALYSIS Phase I Try to envision the possible outcomes from an investment Prepare es8mates and forecast Analysis forms the basis for es8ma8ng an expected value for the investment along with NPV, IRR, and other measures of investment worth Phase II Detail underlying sources of risk. Iden8fy value drivers and uncertainty Seek ways to mi8gate risks and monitor the risks throughout the life of the project
A VALUATION 101 EXAMPLE CSM, Inc., is considering an investment in Earthilizer, a new organic fertilizer made from dairy farm waste Developed by CSM s ag-division over the past 3 years in response to: growing demand from organic farmers more restrictions on the disposal of cattle manure Initial investment of $580K ($250K WC + $330K PPE) Project will be up and running by the end of 2012, with first year of sales in 2013 Project is all-equity-financed Very promising investment opportunity product has undergone extensive testing product is wholly organic, and is cheaper than traditional applications
EARTHILIZER ASSUMPTIONS $580K initial investment at the end of 2012 $250K WC and $330 PPE Straight-line depreciation PPE 10-year life zero salvage value Sales $1million in 2013 growing 10% annually throughout the 5-year planning period 30% tax rate 2013-2017 NWC requirements = 25% of Earthilizer s sales COGS margin 67.40% Operating expenses before depreciation are 10% of sales plus an annual fixed $115K CAPEX $330K in 2012 zero in all future years Project end = 2017 Discount rate for the Earthilizer PFCFs is 13.25%
EARTHILIZER INCOME STATEMENT FORECAST Income Statements 2013 2014 2015 2016 2017 Sales (10% growth per year) 1,000,000 1,100,000 1,210,000 1,331,000 1,464,100 Cost of goods sold -674,000-741,400-815,540-897,094-986,803 Gross profit 326,000 358,600 394,460 433,906 477,297 Operating expenses before depreciation -215,000-225,000-236,000-248,100-261,410 Depreciation expense -33,000-33,000-33,000-33,000-33,000 Earnings before interest and taxes 78,000 100,600 125,460 152,806 182,887 Interest expense 0 0 0 0 0 Earnings before taxes 78,000 100,600 125,460 152,806 182,887 Taxes -23,400-30,180-37,638-45,842-54,866 Net income 54,600 70,420 87,822 106,964 128,021
EARTHILIZER BALANCE SHEET FORECAST Balance sheets 2012 2013 2014 2015 2016 2017 Net working capital 250,000 250,000 275,000 302,500 332,750 366,025 Gross PPE 330,000 330,000 330,000 330,000 330,000 330,000 Less: Accumulated depreciation -33,000-66,000-99,000-132,000-165,000 Net PPE 330,000 297,000 264,000 231,000 198,000 165,000 Total 580,000 547,000 539,000 533,500 530,750 531,025
EARTHILIZER PROJECT FCF FORECAST Cash Flows 2012 2013 2014 2015 2016 2017 EBIT 78,000 100,600 125,460 152,806 182,887 Less: Taxes -23,400-30,180-37,638-45,842-54,866 NOPAT 54,600 70,420 87,822 106,964 128,021 Plus: Depreciation expense 33,000 33,000 33,000 33,000 33,000 Less: CapEx -330,000 0 0 0 0 0 Less: Change in net WC -250,000 0-25,000-27,500-30,250-33,275 Plus: Liquidation of net WC 366,025 Plus: Liquidation of PPE 165,000 Equals: Project Free Cash Flow (PFCF) -580,000 87,600 78,420 93,322 109,714 658,771 Discount factor 1.00 0.88 0.78 0.69 0.61 0.54 Discounted PFCF -580,000 77,351 61,144 64,249 66,698 353,625 NPV 43,067
EARTHILIZER PROJECT ASSESSMENT Discounting the Cash Flows Discount rate for the unlevered PFCFs is 13.25% Present value of the expected project free cash flows from 2013 on is therefore $623,067 The Decision to Invest (or Not): Accept Project! NPV is $623,067 - $580,000 (initial cost) > 0 IRR 15.36% exceeds the discount rate of 13,25% Since this is a risky project and things may not go exactly as planned, CSM needs to learn more about the project to get a better understanding of how confident we should be about the NPV estimate
SENSITIVITY ANALYSIS LEARNING MORE ABOUT THE PROJECT Phase I is complete: We have an NPV estimate of the Earthilizer investment How confident can we be that the project will unfold as we expect? What are the key value drivers of the project that the firm should monitor over the life of the investment to ensure its success? In Phase II we use a variety of tools to address these concerns scenario analysis, breakeven sensitivity analysis, and simulation analysis
SCENARIO ANALYSIS What would happen to the Earthilizer NPV if we applied a pessimistic estimate of the initial sales of $500,000? DCF value drops to $342,790 Negative-NPV investment, We could also analyze scenarios involving multiple sets of changes in assumptions and forecasts. Evaluate the project using optimistic and pessimistic estimates for the value drivers
BREAKEVEN SENSITIVITY ANALYSIS Variable - Forecast or Assumption (1) Expected Value (2) Critical Value (3) % Change (4) Sales growth rate 10.00% 5.66% -43.40% Gross profit margin = Gross profit / Sales 32.60% 31.12% -4.54% Operating expenses (before depreciation) 10.00% 11.48% 14.80% Tax rate 30.00% 40.14% 33.80% Net working capital / Sales 25.00% 33.40% 33.60% Base-year sales for 2012 $1,000,000 $923,171-7.68% * Cri%cal value for each variable is the value that would, holding all other variables equal to their expected value, result in a zero NPV. This cri%cal value is more descrip%vely called the breakeven value since it produces a zero NPV. Variable (1): 6 key variables crucial to NPV were iden8fied in the Earthilizer example Expected Value (2): Expected values for each of the value drivers that we used in our analysis of the project s expected NPV Cri%cal Value (3): Cri8cal or breakeven values for each of the value drivers that result in a zero NPV for the project % Change (4): Compares the expected and cri8cal values for these variables; it calculates the % Change in each variable from its expected value required to produce a zero NPV
BREAKEVEN SENSITIVITY ANALYSIS This analysis suggests that three variables are particularly critical to the outcome of the Earthilizer investment. Very slight deviations from their expected value have a significant impact on project NPV: gross profit margin (% for breakeven = -4.54%) operating expenses as % of sales (% for breakeven = +14.80%) base-year sales for 2008 (% for breakeven = -7.68%).
LIMITATIONS TO BREAKEVEN SENSITIVITY ANALYSIS Considers only one value driver at a time, while holding all others equal to their expected values. This can produce misleading results if two or more of the critical value drivers are correlated with one another. We don t have any idea about the probabilities associated with exceeding or dropping below the breakeven value drivers. No formal way of incorporating consideration for interrelationships among the variables.
MECHANICS OF FORECASTING Let us now focus on the mechanics of forecasting specifically, how to develop an integrated set of financial forecasts that reflect the company s expected performance. 1. The appropriate level of detail. The typical forecast will be split into three time periods: the explicit forecast, a forecast of key value drivers, and continuing value. 2. The mechanics of the forecasting process. To arrive at future cash flow, we forecast the income statement and balance sheet.
THE LENGTH AND DETAIL OF THE FORECAST The explicit forecast period must be long enough for the company to reach a steady state, defined by the following characteristics: The company grows at a constant rate and reinvests a constant proportion of its operating profits into the business each year. In general, use an explicit forecast period of 10 to 15 years perhaps longer for cyclical companies or those experiencing very rapid growth. Using a short explicit forecast period, such as 5 years, typically results in a significant undervaluation of a company or requires heroic long-term growth assumptions in the continuing value.
FORECASTING PROCESS Although the future is unknowable, careful analysis can yield insights into how a company may develop. We break the forecasting process into six steps: 1. Prepare and analyze historical financials. Before forecasting future financials, you must build and analyze historical financials. In many cases, reported financials are overly simplistic. When this occurs, you have to rebuild financial statements with the right balance of detail. 2. Build the revenue forecast. Almost every line item will rely directly or indirectly on revenue. You can estimate future revenue by using either a top-down (marketbased) or bottom-up (customer-based) approach. Forecasts should be consistent with historical evidence on growth. 3. Forecast the income statement. Use the appropriate economic drivers to forecast operating expenses, depreciation, interest income, interest expense, and reported taxes.
FORECASTING PROCESS 4. Forecast the balance sheet: working capital and capital expenditure. 5. Calculate key financials and FCF. Calculate implied operating margin and growth to assure forecasts are consistent with economic principles, industry dynamics, and the company s competitive advantage. To complete the forecast, calculate free cash flow as the basis for valuation. Future FCF should be calculated the same way as historical FCF.
TAKING STOCK A model can be as simple or as complex as needed for the project or type of analysis Model Complexity Key Considerations Quick & Dirty n n n Pitches and internal analysis High level income and cash flow statement line items Leverage brokers and broad assumptions/trends n More details do not necessarily equal more accuracy! - More assumptions mean more room for error - More details add insight into how different factors impact the business financially n Use multiple scenarios! - There is no right answer - Stress-test for extreme circumstances Down & Dirty n n n Live deals and specific client requests Subcomponents of key statement line items Detailed assumptions n Take a step back and ask yourself if the big picture makes sense! - Do the interaction of assumptions fit together? - Use CAGR s and average margins over long periods as a sense test